MODULE 3 – Risk Management of Financial Derivatives

INTRODUCTION
FMELEC1– Risk Management
This module introduces the Market deregulation, growth in global trade, and continuing
technological developments have revolutionized the financial marketplace during the
past two decades. A by-product of this revolution is increased market volatility, which
has led to a corresponding increase in demand for risk management products. This
demand is reflected in the growth of financial derivatives from the standardized futures
and options products of the 1970s to the wide spectrum of over-the-counter (OTC)
products offered and sold in the 1990s.
Many products and instruments are often described as derivatives by the financial
press and market participants. In this guidance, financial derivatives are broadly
defined as instruments that primarily derive their value from the performance of
underlying interest or foreign exchange rates, equity, or commodity prices.
Financial derivatives come in many shapes and forms, including futures, forwards,
swaps, options, structured debt obligations and deposits, and various combinations
thereof. Some are traded on organized exchanges, whereas others are privately
1 negotiated transactions. Derivatives have become an integral part of the financial
MODULE 3 – Risk Management of Financial Derivatives
markets because they can serve several economic functions. Derivatives can be used
to reduce business risks, expand product offerings to customers, trade for profit,
manage capital and funding costs, and alter the risk-reward profile of a particular item
or an entire balance sheet.
Risks Associated with Derivative Activities
Risk is the potential that events, expected or unanticipated, may have an adverse
impact on the bank’s capital and earnings. The OCC has defined nine categories of
risk for bank supervision purposes. These risks are: strategic, reputation, price, foreign
exchange, liquidity, interest rate, credit, transaction, and compliance. These categories
are not mutually exclusive. Any product or service may expose the bank to multiple
risks. For analysis and discussion purposes, however, the OCC identifies and
assesses each risk separately. Derivative activities must be managed with
consideration of all of these risks.
 LEARNING OUTCOMES:
FMELEC1– Risk Management
After reading this module, the learner should be understand to:
1. The framework for evaluating the adequacy of risk management practices of
derivative.
2. The guidance is comprehensive in scope, it provides only a framework.
3. Overview of sound risk management practices for derivatives
4. The technical information on the various aspects of derivatives risk
management, such as evaluating statistical models.

TIME:

The time allotted for this module is 6 hours.

LEARNER DESCRIPTION
2 MODULE 3 – Risk Management of Financial Derivatives
The participants in this module are Business Management and Financial management
students.

MODULE CONTENTS:

LESSON 1: Roles of Management in Financial Derivatives

In this lesson, the management of derivative activities should be

integrated into the organization or company in overall risk
management system using a conceptual framework common
to the other businesses.

Senior Management and Board

It is the responsibility of the board to hire a competent executive management team,
endorse the corporate vision and the overall business strategy (including the
institutional risk appetite), and hold executive management accountable for
performance. The board must understand the role derivatives play in the overall
business strategy.
 It is the responsibility of senior management to ensure the development of risk
management systems. This entails developing and implementing a sound risk
management framework composed of policies and procedures, risk measurement and
reporting systems, and independent oversight and control processes.
FMELEC1– Risk Management

Policies and Procedures

Senior management should ensure that policies identify managerial oversight,

assign
clear responsibility, and require development and implementation of procedures to
guide
the bank's daily activities. Policies should detail authorized activities, as well as
activities
that require one-off approval and activities that are considered inappropriate.

Policies must keep pace with the changing nature of derivative products and
markets.
On an ongoing basis, the board or appropriate committee should review and endorse
significant changes in derivative activities. At least annually, the board, or a designated
3 committee, should also approve
MODULEkey policy statements.
3 – Risk Meeting
Management minutes should
of Financial Derivatives
document these actions.

New Products

New products frequently require different pricing, processing, accounting, and risk
measurement systems. Management and the board must ensure that adequate
knowledge, staffing, technology, and financial resources exist to accommodate the
activity. Furthermore, plans to enter new markets/products should consider the cost of
establishing appropriate controls, as well as attracting professional staff with the
necessary expertise.

The new product approval process should include a sign-off by all relevant areas
such as risk control, operations, accounting, legal, audit, and senior and line
management. Depending on the magnitude of the new product or activity and its
impact on the bank’s risk profile, senior management, and in some cases, the board,
should provide the final approval.

Risk Control
 The role and structure of the risk control function (also referred to as market risk
management at banks with significant trading activities) should be commensurate
with the extent and complexity of the derivative activities.

Risk control units should regularly evaluate risk-taking FMELEC1–

activities byRisk Management
assessing risk
levels and the adequacy of risk management processes. These units should also
monitor the development and implementation of control policies and risk
measurement systems. Risk control personnel staff should periodically communicate
their observations to senior management and the board.

Audit

Audits should be conducted by qualified professionals who are independent of the

business line being audited. Audits should supplement, and not be a substitute for, a
risk control function.

The scope of audit coverage should be commensurate with the level of risk and
volume of activity. The audit should include an appraisal of the adequacy of
operations, compliance, and accounting systems and the effectiveness of internal
controls. Auditors should test compliance with the bank’s policies, including limits.
4 The audit should include anMODULE
evaluation Risk
3 –of the Management
reliability and of Financial
timeliness of Derivatives
information
reported to senior management and the board of directors. Auditors should trace and
verify information provided on risk exposure reports to the underlying data sources.
The audit should include an appraisal of the effectiveness and independence of the
risk management process. Auditors might ensure that risk measurement models,
including algorithms, are properly validated. The audit should include an evaluation of
the adequacy of the derivative valuation process and ensure that it is performed by
parties independent of risk-taking activities. Auditors should test derivative valuation
reports for accuracy.

 Risk Measurement

Accurate measurement of derivative-related risks is necessary for proper monitoring

and control. All significant risks should be measured and integrated into a bank-wide
or corporate-wide risk management system. For example, price risk measurement
should incorporate exposure from derivatives, as well as cash products.

 Risk Limits
 Risk limits serve as a means to control exposures to the various risks associated
with derivative activities. Limits should be integrated across the bank and measured
against aggregate (e.g., individual and geographical) risks. Limits should be
compatible with the nature of the bank's strategies, risk measurement systems, and
the board’s risk tolerance. To ensure consistency between FMELEC1–
limitsRisk
andManagement
business
strategies, the board should annually approve limits as part of the overall budget
process.

 Risk-Adjusted Return Analysis

As measurement and performance systems have continued to develop, techniques

to evaluate business risks and corresponding earnings performance have evolved.
The ability to measure and assess the risk-return relationship of various businesses
has resulted in further steps to measure the risk-adjusted return on capital. This
analysis allows senior management to judge whether the financial performance of
individual business units justifies the risks undertaken.

Management Information Systems

The frequency and composition of board and management reporting should

5 depend upon the nature and 3 – Risk
significance
MODULE of Management of Financial
derivative activities. WhereDerivatives
applicable,
board and management reports should consolidate information across functional
and geographic divisions.

Board and management reporting should be tailored to the intended audience,

providing summary information to senior management and the board and more
detailed information to line management. For example, the board, or designated
committee, should periodically receive information illustrating trends in aggregate
exposure, compliance with business strategies and risk limits, and risk adjusted
return performance. Ideally, management reports should be generated by control
departments independent of the risk-takers.

Personnel and Compensation Plans

Because of their increased complexity, derivative activities require a highly skilled

staff particularly in the risk-taking, risk control, and operational functions.
Management should regularly review the knowledge, skills, and number of people
needed to engage in existing and new derivative activities. They should also ensure
that the staff is appropriately balanced and that no area is understaffed in terms of
skill or number.
 Staff turnover can create serious problems, especially if knowledge is concentrated
in a few individuals. Periodic rotation and cross-training of staff members performing
key functions can help build depth over time and alleviate some of this risk. In
addition, contingency plans should be established addressingFMELEC1– the
Risk loss
Management
of key
personnel. Contingency actions may include curtailing existing or new activities or
outsourcing functions to qualified auditors or consultants.

Management should ensure that compensation programs are sufficient to recruit

and retain experienced staff. However, compensation programs should not
encourage excessive risk-taking. Because of the leverage and volatility associated
with derivatives and the consequent ability to generate large profits in a relatively
short time, employees may be tempted to take excessive risk.

When establishing compensation programs and determining specific payments

(such as bonuses), senior management should consider:

• Individual overall performance.

• Performance relative to the bank’s stated goals.
• Risk-adjusted return.
6 • Compliance with bank policies,
MODULElaws,
3 – and
Riskregulations.
Management of Financial Derivatives
• Competitors’ compensation packages for similar responsibilities and performance.

Statutory responsibilities of management

There has been a developing trend in many countries towards ensuring greater clarity in
regard to the obligations of company directors. The general duties of directors have
developed in the common law over many years in most countries. The Companies Act 2006
in the UK has consolidated the common law duties of directors and codified the general
duties, as follows:
• act in accordance with allocated responsibilities;
• act in accordance with the constitution of the company;
• promote the success of the company;
• exercise independent judgement;
• exercise reasonable care, skill and diligence;
• avoid/declare conflicts of interest;
• not accept benefits from third parties.

The responsibilities of directors are important in relation to risk management and adequate
management of risk will assist in the successful fulfilment of these obligations. Risk
management is particularly important in promoting the success of the organization and
exercising reasonable care, skill and diligence. Directors of organizations need a good
 understanding of risk management so that they will be in a better position to fulfil their
statutory and other duties.

Role of the risk manager

FMELEC1– Risk Management
There is no single established reporting position in the structure of an organization for the risk
manager. At present, risk managers may report to human resources, the fi nance director or
the
company secretary. Sometimes, the risk manager is a report to the corporate treasurer and,
occasionally, the chief executive officer (CEO).

Chief risk officer (CRO)

The introduction of the job title Chief Risk Officer (CRO) is not universal, but it is becoming
common in the specialist finance and energy sectors. Guardian of the risk architecture, strategy
and protocols (GRASP) is a superior description of the role that must be fulfilled.

Activity 3.1:

 Using your own creativity, drawn your organization structure based on the topic
discussed. Site the duties and responsibilities of each position?
7 3 – Risk Management
MODULEoperation
 Is it important in business be aware ofofroles
Financial
and Derivatives
responsibilities in the organization?

References:

 Borghesi and B. Gaudenzi, Risk Management, Perspectives in Business Culture, DOI:

10.1007/978-88-470-2531-8_9, Springer-Verlag Italia 2015
 Hopkin, Paul. Fundamentals of risk management: understanding, evaluating, and
implementing effective risk management / Paul Hopkin,2015
 Online Comptroller of the Currency Administrator of National Banks, As of January 12,
2012, this guidance applies to federal savings associations in addition to national
banks.

ONLINE READING MATERIALS:

ONLINE VIDEO LINKS AND MATERIALS:

  Watch the online video lecture of the course instructor uploaded at NEO LMS and to
the class shared Google drive (if applicable).


FMELEC1– Risk Management

TEST YOUR KNOWLEDGE:
 Take your 3rd Quiz on LMS given by the professor.

MODULE REFERENCES:

 Borghesi and B. Gaudenzi, Risk Management, Perspectives in Business Culture, DOI:

10.1007/978-88-470-2531-8_9, Springer-Verlag Italia 2015
 Hopkin, Paul. Fundamentals of risk management: understanding, evaluating, and
implementing effective risk management / Paul Hopkin,2015
 Online Comptroller of the Currency Administrator of National Banks, As of January 12,
2012, this guidance applies to federal savings associations in addition to national
banks.

8 MODULE 3 – Risk Management of Financial Derivatives